A bear market is traditionally defined as a period of negative returns in the broader market where stock prices fall 20% or more from recent highs. Several strategies can be used when investors believe that this market is about to occur or is occurring; the best approach depends on the investor's risk tolerance, investment time horizon, and overall objectives.

Key Takeaways

  • Several strategies exist to deal with a bear market, defined as sustained periods of downward trending stock prices, often triggered by a 20% market decline.
  • Cashing out all positions is one approach.
  • Buying defensive stocks—large-cap, stable companies, especially those involved with consumer staples—is another.
  • Yet another strategy is to go bargain-hunting, taking advantage of depressed prices to snap up fundamentally strong stocks.

Selling Out

One of the safest strategies, and the most extreme, is to sell all of your investments and either hold cash or invest the proceeds into much more stable financial instruments, such as short-term government bonds. By doing this, an investor can reduce their exposure to the stock market and minimize the effects of the raging bear.

That said, most, if not all investors, have no ability to time the market with accuracy. Selling everything, also known as capitulation, can cause an investor to miss the rebound and lose out on the upside.

For those who want to profit from a falling market, short positions can be taken in several ways, including short selling, buying shares of an inverse ETF, or buying speculative put options, all of which will increase in value as the market declines. Note that each of these short strategies also comes with its own set of unique risks and limitations.

Playing Defense

For investors looking to maintain positions in the stock market, a defensive strategy is usually taken. This type of strategy involves investing in larger companies with strong balance sheets and a long operational history: stable, large-cap companies tend to be less affected by an overall downturn in the economy or stock market, making their share prices less susceptible to a larger fall.

These so-called defensive stocks also include companies that service the needs of businesses and consumers, such as food purveyors (people still eat even when the economy is in a downturn) or producers of other staples, like toiletries. With strong financial positions, including a large cash position to meet ongoing operational expenses, these companies are more likely to survive downturns.

On the other hand, it is the riskier companies, such as small growth companies, that are typically avoided because they are less likely to have the financial security that is required to survive downturns.

Protective Put Options

One big way to play defense is to buy protective put options. Puts are options contracts that give the holder the right, but not the obligation, to sell some security at a predetermined price once or before the contract expires. So, if you hold 100 shares of the SPY S&P 500 ETF from $250, you can buy the $210 strike puts that expire in six months, for which you will have to pay the option's premium (option price).

In this case, if the SPY falls to $200, you retain the right to sell shares at $210, which means you've essentially locked in $210 as your floor and stemmed any further losses. Even if the price of SPY falls to only $225, the price of those put options may increase in market value since the strike price is now closer to the market price.

The bear market that began on March 11, 2020, was arguably caused by many factors, but the immediate catalyst was the spread of the COVID-19 pandemic.

Shopping for Bargains

A bear market can be an opportunity to buy more stocks at cheaper prices. The best way to invest can be a strategy called dollar-cost averaging. Here, you invest a small, fixed amount, say $1,000, in the stock market every month regardless of how bleak the headlines are. Invest in stocks that have value and that also pay dividends; since dividends account for a big part of gains from equities, owning them makes the bear markets shorter and less painful to weather.

Diversifying your portfolio to include alternative investments whose performance is non-correlated with (that is, contrary to) stock and bond markets is valuable, too. For instance, when stocks crash, bonds tend to rise as investors seek safer assets (although this is not always the case).

The Bottom Line

These are just two of the more common strategies tailored to a bear market. The most important thing is to understand that a bear market can be a very difficult one for long investors because most stocks fall over the period of a bear market, and most strategies can only limit the amount of downside exposure, not eliminate it.